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Federal Reserve Governor Daniel Tarullo Reconsiders the Volcker Rule

In his parting speech as a member of the Board of Governors of the Federal Reserve System (“FRB”), Governor Daniel K. Tarullo asserted “that strong capital requirements are central to a safe and stable financial system.” He described the post-crisis atmosphere in which regulatory capital requirements were first proposed, and evaluated the subsequent adoption of the Dodd-Frank Act. Noting that a statute as broad as Dodd-Frank could not possibly get everything right, Governor Tarullo cited the Volcker Rule as an area where the “case for change has become fairly strong”:

[T]he Volcker rule is too complicated. Achieving compliance under the current approach would consume too many supervisory, as well as bank, resources relative to the implementation and oversight of other prudential standards. And although the evidence is still more anecdotal than systematic, it may be having a deleterious effect on market making, particularly for some less liquid issues.”

Governor Tarullo identified the following flaws in the Volcker Rule: (i) it involves five regulatory agencies, (ii) it contemplates evaluating the mindset of a trader at the time a trade is made, and (iii) it applies to a much broader group of banks (including community banks) than necessary.

Governor Tarullo championed the “risk-based” capital approach as the best post-crisis capital buffer, noting that no single measure of capital would be appropriate. He advocated moving toward a simpler approach for community banks and rejected a recent proposal to implement a broad leverage ratio, increased to 10 percent, as a substitute for existing regulation. He argued that a higher leverage ratio would “make banks less profitable, and . . . they would be strongly incentivized to change the composition of their balance sheets dramatically, shedding safer and more liquid assets” if the new ratio became the predominant regulatory feature.

Governor Tarullo also evaluated the unfinished “transition of stress testing from crisis program to a permanent feature of prudential oversight.” He stated that for stress testing to succeed, it must evolve along with the financial system. He opposed removing capital distributions from the stress-test regime claiming that it would result in fewer protections for the financial system.